Big banks dump the risk on investors

Commentary: Also, dealmaking returns and so do suspicious trades

By

DavidWeidner

NEW YORK (MarketWatch) -- Wall Street finally found a buyer for all of that bad debt on its books: the regular investor.

After the single biggest wave of credit-related write-downs in Wall Street history, more than $20 billion and growing, it's investors who are holding the risk. For example, Merrill Lynch & Co.
MER, -1.13%
on Friday announced a $5.5 billion charge, the Street's biggest, and immediately investors sent the stock up 2.5%. See full story

"The theory that if the company writes off $2 billion it should see its stock price up $1 and if it writes off $6 billion the stock should jump $3 is not one I can embrace."
Dick Bove,Punk Ziegal &amp; Co.

Merrill simply followed the path laid down by Citigroup Inc.
C, +1.23%
which wrote off $3.3 billion and Deutsche Bank AG
DB, +0.35%
which wrote off $3.1 billion and Morgan Stanley
MS, +1.08%
$940 million. All saw their stock rise after dropping the write-down bomb.

The bet is that the bigger the write-down now, the less these institutions will have to write down in the future. This is like a baseball team that celebrates after losing by nine runs, because the odds seem somehow greater that it will lose the next game by a big margin. This logic has Richard Bove, an analyst at Punk Ziegal & Co., flabbergasted.

"These companies are not going to see their markets jump back immediately," he wrote in a note to clients. "Their earnings power has been lowered. This is a reason to sell not buy. The theory that if the company writes off $2 billion it should see its stock price up $1 and if it writes off $6 billion the stock should jump $3 is not one I can embrace."

The Amex Securities Broker/Dealer Index
$XBD
is up 8.5% since Lehman Bros. Holdings Inc.
LEH
was the first to detail credit-related write-downs before the market opened Sept. 18.

This investment strategy of rewarding companies with losses or even more so than those with profits turns the conventional wisdom of rewarding well-run companies on its head. The credit crisis is over, but the boom times are not back.

Analysts caution that the fixed-income, currency and commodities trading businesses have slowed. That decline is troubling because unlike write-downs, poor business conditions aren't one-time events.

Only one investment bank, Goldman Sachs Group Inc.
GS, +1.19%
seemed to dodge the credit bullet. Its earnings rose 79% in spite of $3 billion in write-downs and adjustments. Bloomberg crowned Goldman's' hedge fund-like strategy the new Wall Street model.

But how long will that last? Goldman's golden touch didn't work for investors in its Equity Opportunities and Global Alpha hedge funds.

Investors should take a step back. Bove says they shouldn't assume the Federal Reserve fixed the environment for investment banking, that Wall Street has identified all of the risks and losses, that profits will "snap back" to pre-credit crisis levels and that stocks priced in the write-downs.

They should, in essence, let the banks take the risks.

Big coincidence

It's been weeks since we've seen any suspicious trading before a big deal announcement. Unfortunately, the bad guys aren't sitting on their hands. It's been weeks since we've seen any big deal announcements.

But the freeze thawed recently when the dollar's tumble in the world currency markets helped Toronto-Dominion Bank
TD, +1.27%
to acquire Commerce Bancorp
CBH, +0.44%
the Cherry Hill, N.J.-based bank for $8.5 billion.

Most deals with suspicious pre-announcement trading this year have come from deals where the buyers are private equity firms. But in this case, TD is an old fashioned strategic buyer.

And some buyers strategically began buying call options in Commerce as early as last Friday, Sept. 28. More than 5,800 contracts changed hands that day. That's a nice bump considering only 74 call options traded the day before. By Monday, the eve of the deal, 9,615 call options were traded, about three-times the average daily volume in September, according to the OCC.

The problem for the speculators was that the October call options were to buy Commerce at $42.50. The deal went down at $40.59 a share, only a 2% premium. It's one thing to have inside information; it's another to have all of it.

Now, to be fair, Commerce shareholders have anticipated a sale since Vernon Hill was forced to resign as chairman and chief executive in June. Shares spiked about 15% in the wake of his exit and Commerce has been riding takeover speculation ever since.

But the price and the volume both took big jumps on Oct. 1. Volume was 2.28 million shares, up from just 753,000 shares on Sept. 27. The stock closed at $39.74, a 52-week high.

Some investors seemed to have a feeling that Commerce was a little bit more than over the Hill.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.